Can oil prices predict the direction of exchange rate movements? An empirical and economic analysis for the case of India

This study investigates whether oil prices have enough predictive information to predict the direction of the movement of exchange rate by examining the type of cointegration relationship between exchange rate and oil prices in India between 1991Q1 and 2013Q1. Our findings suggest the existence of cointegration relationship between exchange rate and oil prices using both Engle-Granger two-step cointegration test and Johansen cointegration test. Using a momentum threshold autoregressive consistent model, we find evidence in favour of asymmetric cointegration between the two variables. Nevertheless we find no evidence to support asymmetric cointegration relationship between the two variables when threshold autoregressive, threshold autoregressive consistent, and momentum threshold autoregressive models are used. Thus, the results suggest that for certain time period, the adjustment process between exchange rate and oil price is constant, which makes it conducive for predicting the direction of exchange rate movement. However, evidence of asymmetric cointegration suggests that the stable relationship is likely to be interrupted with intervals of structural change implying correction in the dynamics of influencing factors.